RBS claims Europe is in Deflation Motel: 'you can check in, but you can’t
check out'

The European Central Bank will be forced to boost its balance sheet to €4.5 trillion in a colossal monetary blitz to prevent deflation engulfing the eurozone, economists at RBS have warned.

The figure is the most aggressive forecast issued so far by any major bank and implies quantitative easing (QE) of at least €2.3 trillion, two or even three times the level suggested so far by ECB officials.

It comes amid a blizzard of leaks from Frankfurt over the size and shape of QE as the ECB prepares for a pivotal decision next week. Most analysts say sovereign bond purchases are almost certain after the currency bloc slumped into deflation in December, though legal and political barriers complicate the picture.

The RBS report, entitled “Deflation Motel: you can check in, but you can’t check out”, said the buying spree will drive 10-year yields to near zero or even lower in the core countries. The German Bund yield will continue to smash historic records, dropping to 0.13pc by the end of this quarter, pulling Italian yields down to 1pc.

“It is very easy to make a case over coming months for negative 10-year Bund yields. We are increasingly asking ourselves the question, who on Earth is the ECB going to be buying them from,” said Andrew Roberts, the bank’s credit chief. “It is Japanification no longer. It goes even further.”

Germany plans a budget surplus this year that will cause Bund issuance to dry up. The report said Germany’s debt agency will cancel a net €18bn of bonds next year with maturities from five to 30 years. This scarcity of new debt will continue since a constitutional amendment is coming into force that makes a balanced budget obligatory.

The Bundesbank may have to find other ways of conducting QE, opting instead to buy the debt of the German Lander or the state development bank KfW.

The report said the first blast of QE to be unveiled next week – though not necessarily enacted immediately – will fail to stop the slide towards debt-deflation as powerful deflationary pressures from Asia and the global effects of China’s excess capacity overwhelm Europe’s defences.

The five-year/five-year forward swap rates tracked by the ECB as a "pure" indicator of long-term inflation expectations have collapsed to 1.54pc, 40 basis points lower than they were when the ECB’s Mario Draghi first warned they were signalling trouble.

RBS said combined variants of QE will run at about €30bn a month over the first phase. This is far less than the bond-buying in the US, Britain and Japan as a share of GDP. It is unlikely to have much macro-economic effect at this late stage. “They are behind the curve but if core inflation falls to zero, the volume of QE could accelerate very quickly,” said Giles Gale, the bank’s rates strategist.

Regardless of the economic effects, RBS said even the first tranche of QE will be enough to set off a further a dash for bonds and flood global markets with enough liquidity to keep the asset boom going as the US Federal Reserve steps back. RBS advised clients to buy “everything”, except for commodities and Asian assets.

This mix of stagnant wages and booming wealth is widely-seen as corrosive for Western societies. Critics of QE - or at least QE as currently conducted – warn that political systems will start to fray if this divergence goes on for much longer, but there is little sign yet that central banks are ready to think of other ways to inject the stimulus.

The ECB is examining a menu of options for its bond purchases. The most likely formula is QE based on the bank’s “capital key”, akin to buying debt in proportion to each country’s GDP. This has asymmetric effects since Estonia has almost no debt, while Italy’s is 133pc of GDP.

A German-led bloc of hawks has been trying to head off any form of debt mutualisation or fiscal union by the back door. This may lead to a messy compromise where the central bank of each country buys its own national debt rather than sharing the risk.

This has been condemned by analysts as recipe for trouble, further fragmenting the currency union. But RBS said it is largely a disguise to disarm the “Teutonic press”. The Bundesbank and others would remain on the hook through the ECB’s so-called Target2 payments system, which would lead to de facto risk-sharing on a very large scale if the EMU storm ever returned.

Nevertheless, such a formula may create a perverse incentive for any country in severe crisis to leave the euro so that it could default on its Target2 liabilities without repudiating its own internal debt. RBS did not name any country but the clear implication is that this might raise the temptation for Italy to break free now if ever faced with ugly alternatives.

“Making EMU exit more relatively attractive compared to default looks to us to be a serious possible unintended consequence of this style of QE,” said the report.